Risk-Based Allocation of Principal Portfolios
21 Pages Posted: 1 Apr 2013 Last revised: 14 Apr 2013
Date Written: April 10, 2013
Risk-based asset allocation strategies are mainly used to diversify nominal asset weights. In this paper, we discuss the diversification of risk factors. The analysis is based on the idea of Partovi and Caputo (2004), who use principal component analysis to transform a portfolio into a set of uncorrelated principal portfolios. Risk-based asset allocation strategies can be applied to these uncorrelated sources of risk. A similar route has been taken by Meucci (2009) with his idea of a maximum entropy portfolio. We discuss the relation of this approach with the concept of principal risk parity. Both strategies are backtested against nominal diversification strategies in a multi-asset portfolio. We find no evidence that risk diversification does outperform nominal diversification and discuss possible reasons for this.
Keywords: Asset allocation, portfolio optimization
JEL Classification: G11
Suggested Citation: Suggested Citation